What’s Behind the Tax Gap?

Of all the numbers cited by Nina Olson, the Taxpayer Advocate in her analysis of the Tax Gap as part of her annual report to Congress, one stands out – the $2,200 “surtax” that individuals pay to subsidize noncompliance by others. Preliminary figures suggest that noncompliance for 2005 will approach $290 billion. Basker Johnson, Fred Imel and Kent West of the Oklahoma Society of CPAs spoke with AccountingWEB about what’s behind noncompliance and what the Internal Revenue Service (IRS) can do and is doing to close this gap.

In last year’s Annual Report to Congress, Olson identified “underreported income (and related self-employment tax) from the so called “cash economy” [as] probably the single largest component of the “tax gap.” Returning to the problem of underreporting in 2006 the report says that Internal Revenue Service (IRS) data indicate that 99-percent of income earned by wage earners is reported on a tax return, yet only about 43-percent of income earned by self-employed persons is reported.

Basker Johnson, who is a practicing CPA in Sapulpa, Oklahoma, thinks the noncompliance figure, 80-percent of which comes from underreported income, is probably well understated. He sees two contributing factors – the highly visible cash economy and self employed individuals, who provide paraprofessional services like information technology, setting themselves up as corporations.

Since employers or clients are not required to issue 1099’s to corporations, the IRS has no way to document total income of individuals who have set themselves up this way. The IRS does a pretty good job of matching up 1099 Misc. with Schedule C, Johnson says, but should require that 1099s be issued to corporations. Kent L. West, whose CPA firm is in Mooreland, Oklahoma, agrees and says that he can’t understand why the IRS does not issue 1099s to corporations. West thinks that the use of 1099s should be expanded -- to report payment for services, material and labor.

For many small businesses, the incentives to pay wages in cash– avoiding paying payroll taxes and workers comp insurance -- are very powerful, Johnson says. He cites a client, a contractor who had consistently issued W-2s to all of his workers who was also consistently underbid by other contractors who paid in cash.

The IRS estimates that excessive deductions represent only 20 percent of the gap. Nevertheless, some deductions for home office are a problem, Johnson says, because they may not be business-related.

Fred Imel, whose practice is in Yukon, Oklahoma, points out that in the larger society there is an assumption that everyone will be paying his or her fair share, but he did not assign the blame exclusively to individuals who are engaged in the cash economy.

Accountants are not employees of the government, Imel says, but as citizens they share the feelings of the public the tax system should apply to everyone. They also have an important role to play. “If a client breaks the law, and some will tell their accountants because they want someone to share the guilt,’ he says, “the accountant has the obligation to change the client’s tax position or fire the client.”

“There is also a certain element of culture behind the cash economy that is hard to combat,” Imel says. “If your Daddy and Granddaddy transacted some of their business in cash, it doesn’t seem so bad.”

West points out that it can get pretty expensive when a business owner is caught in an IRS audit because he deducted employee wages as a business expense, but did not issue W-2s and pay employment taxes, and the IRS reclassifies the deduction as wages. “He has to pay Social Security and Medicare taxes at both ends, state taxes, insurance, penalties and interest.” West says that some business owners pay cash wages to help workers avoid garnishments.

IRS enforcement efforts directed at individuals who are engaged in the cash economy have been limited, the Taxpayer Advocate report says, “because at a practical level, the IRS lacks the resources to close the tax gap through audits alone. The examination rate is currently less than one percent, and the majority of examinations are limited-scope examinations conducted by mail.” The Report suggests that enforcement actions be “targeted to combat clear abuses and send a message to all taxpayers that noncompliance has consequences.”

Baxter Jonhson blames Congress, “because it has not funded the IRS enforcement efforts. It needs to drastically increase funding for auditors and training. The IRS needs to drastically increase the number of audits it performs to possibly as many as six-percent of returns filed.”

Auditor training also needs to be enhanced, Johnson says. “The IRS should increase the number of audits at least 2-3 percent possibly even to six-percent of returns filed, and put better trained auditors in the field who are more motivated.”

Computer audits are useful, but to make a dent in the impact of the cash economy, Johnson says, the auditors should be in the field “looking at bank statements and lifestyle.”

Fred Imel's experience with the IRS in recent audits has been that they are much more professional and fair than they used to be. “They have high-level analytical thinking tools, come well-prepared and conclude their business quickly,” he says. “Enforcement will be weakened, though,” he adds, based on a conversation with an IRS official, “because so many senior agents are retiring and the IRS cannot hire enough people to replace them.” Imel also says that the IRS lacks training capacity.

Johnson questions the IRS commitment to providing taxpayer assistance, at least when it comes to connecting with a live person on the phone. “The word 'service' should be taken out of the name of the IRS. A caller needs to go through several menus to talk to a person on the phone and then need to tell his story over and over again to agents before he can resolve a simple issue. It raises the problem for accountants, too, of whether they can bill for the time spent on the phone.”

Olson arrived at the “surtax” figure by dividing the estimated $290 billion net tax gap by the roughly 130 million individual income tax returns filed, the Taxpayer Advocate Report says.

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